Volume 48 July 2019

3 ROE REPORTER | DKAM rates are heading lower and stock indexes are hitting all-time highs. This has prompted several questions about lower rates and the impact on investments. There are two main issues at play here. The first, more straight forward matter is that lower interest rates make businesses more profitable. The second more nuanced issue is the impact lower interest rates have on the relative value of one investment over another. At any point in time, there is a finite amount of investable capital that looks to find a suitable return and a finite number of possible investments. For instance, a pension fund is always trying to obtain a sufficient return in order to satisfy their pension obligations. For example, the Canadian Pension Plan uses a 3.55% net annual return (after fees and inflation) in their actuarial report. As you can imagine, as interest rates fall, bond yields fall (government debt currently has a negative yield in over 30 countries), and the menu of investments that generate a satisfactory return becomes smaller and smaller. The answer is to stretch on capital risk and/or liquidity risk to achieve return. Investors are stretching on the risk spectrum in fixed income to get a satisfactory yield. The same dynamic is occurring across other asset classes including real-estate and private equity. To get a handle on which way capital will most likely be flowing, we track the equity risk premium. The equity risk premium is a relative measure that aims to compare how expensive the stock market is versus how expensive the bond market is. The ratio does this by using the earnings yield of the stock market (inverse of the Price to Earnings Ratio) and dividing it by the yield on investment grade bonds, so higher numbers represent stocks offering more value than bonds (Figure 2). The chart illustrates, on a 25 year timeline, the relative basis that stocks appear to be more attractive than bonds. With interest rates set to decline even further at the end of July, stocks will only get more attractive. Figure 2. Source: Bloomberg